Now that the U.S. Federal Reserve’s dreaded taper has arrived, some in India are wondering whether the rupee is headed for new lows again. A recent paper by two economists provides some clues.

Many emerging markets took a thumping this summer after the Fed first hinted it might scale back its monthly asset purchases. But India got it the worst.

Advertisement

The rupee collapsed after Ben Bernanke testified before the U.S. Congress in May, and stocks tanked. In July, the Reserve Bank of India had to implement emergency measures to curb liquidity and protect the currency’s value. The rupee hit an all-time low in late August after notching its worst daily performance since 1995 and its worst monthly performance since 1993.

A more important factor, they wrote, was simply the size of a country’s financial market. Giants like Brazil, India and South Africa experienced bigger swings in their real exchange rates than minnows like Armenia, Bosnia and Herzegovina, and Albania.

Why? When it looked like long-term interest rates in the U.S. would start to rise again, investors focused their selling on developing countries with large, liquid markets where they could exit easily without taking big losses.

“This is a reminder,” the authors wrote, “that success at growing the financial sector can be a mixed blessing. Among other things, it can accentuate the impact on an economy of financial shocks emanating from outside.”

The paper used data from 55 emerging market countries. It defined financial-market size as total private inflows of equity, bonds and loans.

Mr. Eichengreen and Ms. Gupta also found that the effects of taper talk were correlated, perhaps not surprisingly, with indicators related to capital flows. Countries that had allowed their real exchange rates and current-account deficits to increase most dramatically during the period of Fed easing were affected most.

Crucially, however, neither fiscal tightening nor capital controls were important determinants of the taper reaction, the authors found. Their interpretation is that sound financial oversight mattered more. The countries that kept bank lending from overheating or becoming excessively risky as hot money flowed in from overseas, were the countries that remained relatively stable when the Fed said it would withdraw the money tide.

The importance of sound financial-sector policy presumably still applies today, now that the taper is truly upon us. India has used the months since the summer scare to narrow its current-account gap by blunt force, capping imports of gold and other goods. The Indian government is also hoping to meet its budget-deficit target by extracting a one-off dividend from state-run companies.

But financial reforms have been slow. In October, India’s new central-bank governor, Raghuram Rajan, proposed five “pillars” of reform for creating deeper, more liquid credit markets and improving the system’s ability to deal with corporate and bank distress. None of them are beyond early stages yet.

Still, the impact of the taper should be less severe this time, Ms. Gupta told The Wall Street Journal.

Investors already used India’s easy to exit markets to rebalance their portfolios this summer, and India has made some smart policy moves since then.

“The rupee is better-priced now than it was in June; the current-account deficit has narrowed; reserve cover is larger; and political uncertainty is perhaps somewhat diminished,” Ms. Gupta said. “Last but not least, there seems to be better communication and guidance from the RBI, restoring confidence.”

About India Real Time

India Real Time offers analysis and insights into the broad range of developments in business, markets, the economy, politics, culture, sports, and entertainment that take place every single day in the world’s largest democracy. Regular posts from Wall Street Journal and Dow Jones Newswires reporters around the country provide a unique take on the main stories in the news, shed light on what else mattered and why, and give global readers a snapshot of what Indians have been talking about all week. You can contact the editors at indiarealtime(at)wsj(dot)com.